Picked The Right Stock? Make Sure You Pick The Right Option

Anyone who has ever traded options knows that it is no easy feat. Unlike trading in stocks, in which your only worry is having the stock move opposite of your intended direction, option traders have much more to worry about, such as:

• Did I pick the right type (call or put) of option?
• Did I pick the right strike price?
• Did I pick the right expiration?

With all of these dilemmas to overcome, one should trade options only when they have some type of ”edge”.

When buying options, you can have that edge when you buy “cheap” options.  So how do you know when an option is “cheap”?

Well first off, options are priced using a model such as the popular Black Scholes options pricing model.  The Black Scholes uses these determinants:

• Price of underlying

• Striking price

• Time until expiration

• Interest rates

• Dividends

•  Volatility

All of these are put into the model and then the model will spit out a number know as the “theoretical value.” The theoretical price is the price of the option calculated by this particular model. It doesn’t mean that this is the actual price of the option in the market.

All of the determinants of an option’s price are known with certainty except for volatility. It is the level of volatility that determines whether the option is cheap or expensive. The volatility inputted into the model is usually the historical or statistical volatility. The historical (statistical) volatility may or may not give you the correct price of an option. 

However the implied volatility or the level of volatility that justifies an option’s current price could be used to compare against an option’s historical volatility to determine whether an option is cheap or expensive. Since the implied volatility is the market’s best estimate of volatility, why mess with that?

Many stock traders I know occasionally buy calls or puts when they have a very strong opinion about the short-term direction of a stock. They are allured by the high degree of leverage available through options.However, this is very risk strategy because, with options, you not only have to face the possibility that that leverage could work against you if your prediction is wrong, but also there’s:

• The value of the option decreases as it gets closer to expiration.
• You have a limited amount time which the move most occur
• The option most close over the strike price for it to be worth anything at expiration

But let’s say that you are fully aware of the risks, and you run across a setup in which numerous patterns and indicators are all lining up in your favor. You decide that you can tolerate the greater risk of buying an option in this case because you have an “edge” predicting the direction of the stock.

That’s Edge #1. Let’s take a close look at a recent example.

Look above at the daily chart of Verisign ((VRSN | Quote | Chart | News | PowerRating), there is a lot of resistance at 56.85.  On 8/02/01, VRSN peaked above that resistance but failed to close above it.  The next day, it closed under the 50 day moving average. 

Is there a way to increase the odds of success even further? Yes…by looking at the options of the underlying stock, we have the potential for identifying Edge #2.

You could have played Verisign using options since the implied volatility of 75.7% is lower than the historical or statistical volatility at 95.3%.  Thus options were cheap compared to historical standards.

There are two reasons why low volatility makes this an attractive opportunity.

• Volatility tends to revert to the mean. So when volatility hits an extreme low, it is highly likely that volatility will snap back to the norm at some point. That would support your conclusion about the likelihood of a major move in Versign.

• The options are cheap, therefore you have a theoretical edge.

Always keep in mind, however, that just because an option is cheap, it doesn’t mean that you should automatically buy the option just like a robot.  You must have some other reasons for taking action. Whether you’re taking action because of a pullback in a stock or you feel that the release of a new product will take the world by storm, have another reason.  Although buying cheap options will give you an edge, but just having an edge by itself is not enough.